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Payday Lenders Strike Back

They counter the FDIC's move with a new product. Will it pay off for shareholders?

Despite some Texas-sized hurdles, payday lenders are finding ways to make money again. Will a new product be enough to fight off regulatory action and languishing stock prices?

Back in early March, the Federal Deposit Insurance Corp. issued new guidelines for payday lenders, or PDLs, that offered loans via a relationship with a third-party bank. In short, the FDIC essentially put the kibosh on the whole practice, resulting in potentially massive revenue cuts for First Cash Financial Services(NASDAQ:FCFS), EZ Corp(NASDAQ:EZPW), Cash America International(NYSE:CSH), QC Holdings(NASDAQ:QCCO), Advance America(NYSE:AEA), ACE Cash Express(NASDAQ:AACE), and Dollar Financial (NASDAQ:DLLR). The stocks all cratered by 35% to 50%.

But necessity is the mother of invention, and the PDLs found a way to circumvent these unfair restrictions in several states -- the most important being Texas, where the vast majority of their revenue was threatened. First Cash, Advance America, and Cash America International announced that they have formed wholly owned subsidiaries called credit services organizations (CSOs). Now, when customers seek a short-term loan against their next paycheck, they'll notice a change in how they receive that loan, but it will essentially be the same old payday loan they've come to know and love. Here's how Advance America President John Egeland explained it:

A customer who enters a payday lending store will fill out the CSO paperwork and receive their loan, much as they did before under the PDL system. However, the money for this loan will not come from a third-party bank, but from what is called a third-party unregistered lender under Texas law. In the case of Advance America, this unregistered lender is a separate LLC [limited liability company] with $20 million to loan out. This LLC does not employ, nor does it consist of, any Advance America employees.

Advance America collects three fees from the customer: (1) A referral fee, for referring the customer to the LLC that will fund the loan, of $20 per $100 borrowed; (2) an application fee for filling out the CSO paperwork, which is about $10 per $100 borrowed, and (3) the interest for the loan, which state law caps at $10 per $100 borrowed. The payday lender or CSO keeps the referral fee; the other two fees go to the LLC.

Who carries the default risk? The payday lender, leaving the LLC free and clear of any risk. And the payday lender doesn't have much to worry about, either. The ultimate default rate is 2% of gross loan receivables, and Egeland sees no reason why that number will change. The CSO will also submit credit applications to the LLC, which has the ultimate decision over whether to approve or deny the loan.

Thus, everybody wins. According to Egeland, the payday lender (now operating through its CSO subsidiary) should maintain roughly the same revenue it had before the whole FDIC debacle. Texas earnings will not be affected. The LLC wins because it'll pull in a 20% return while assuming no risk whatsoever. Customers win because they will no longer be restricted to three loans per year and will pay about the same per loan as they did before. (The additional CSO fees will be offset by a lower interest rate.) The best part is that this structure is unlikely to be challenged by any regulatory body: The matter has gone to federal court, and the CSO structure was allowed to stand.

How does this ultimately play out for all the payday lenders and their stocks? Well, first, it is not a cure-all. Although CSO structures are permitted in other states, not all of them are as permissive as the structure in Texas. Advance America expects to keep all of the revenue in Texas and Michigan from before the FDIC restrictions, but it expects to lose about 40% of its revenue in Pennsylvania, Arkansas, and North Carolina. Another product that the FDIC has permitted will allow payday loans through a third-party bank, but those loans can now be paid off bimonthly over four months instead of in the traditional two weeks, amortizing to zero over the same period, generating less revenue in those states.

The sector's other players -- EZ Corp, Dollar Financial, and QC Holdings -- have not yet said they'll form CSOs in Texas. ACE Cash Express has said it would consider forming a CSO in Texas, and probably will, but did not provide the level of detail in its press releases that the other companies did.

Who are the biggest winners? The ones who had been the biggest losers, of course. Check out this chart, which showed the PDL revenue at risk just after the FDIC made its announcement, and after the CSOs were formed -- as well as a few other interesting valuation metrics for those that provided guidance:

First Cash

Cash America

Advance America

ACE Cash

% revenues affected (after FDIC)

17

10.5

22.4

9.5

% revenues affected (current)

0

7.0

5.7

6.0

Earnings growth rate

23%

7%

2%

10%

P/E

18

11

14

14

PEG

0.78

1.6

7.0

1.4

Stock price (July 29)

$24

$21

$15

$24

Decline from high

12%

30%

38%

21%

Now, before you jump to conclusions about these charts, we need to note a few things. Well, actually, you can jump to conclusions about First Cash. It is totally in the clear, and judging how the market has still not absorbed this good news, it looks substantially undervalued.

Cash America is still shrugging off an earnings warning in addition to the FDIC problem, so while I still don't see it as a buy candidate, it's worth watching. Advance America's numbers are a bit deceiving. The company just went public last year, so its income statements and balance sheets need careful perusal: Remember you'll be dealing with pro forma results and anomalies like pay raises that go along with an IPO. One thing is certain: I was very impressed by management in my conversations (I also spoke with CEO Billy Webster), its expansion strategy is sound, and its same-store sales are in great shape. It also has excellent command of its balance sheet. The stock price is still 33% off its high, and I think that price doesn't reflect the vastly improved situation there. ACE Cash Express is hard to evaluate because it hasn't yet detailed its strategy about CSOs.

There is a great lesson here for investors. Management is so important to any company. When you have people like those at First Cash and Advance America, who are able to quickly and effectively respond to a crisis, that counts for a heck of a lot. Remember, the FDIC restrictions came out of nowhere, the Texas payday-lending bill was killed in early May, and less than two months later these companies had a new plan.

With the demand for payday loans clearly established, meddling regulatory agencies out of the way, and growth plans firmly established, it's time to look again at payday lenders.